Dan Mitchell describes three possible government responses to an impending bank failure:

In a free market, it’s easy to understand what happens when a financial institution becomes insolvent. It goes into bankruptcy, wiping out shareholders. The institution is then liquidated and the recovered money is used to partially pay of depositors, bondholders, and other creditors based on the underlying contracts and laws.

In a system with government-imposed deposit insurance, taxpayers are on the hook to compensate depositors when the liquidation occurs. This is what is called the “FDIC resolution” approach in the United States.

And in a system of cronyism, the government gives taxpayer money directly to the banks, which protects depositors but also bails out the shareholders and bondholders and allows the institutions to continue operating.

I would argue that in fact Cyprus has gone off the board and chosen a fourth option: In addition to bailing out shareholder and bondholders with taxpayer money, it will protect them by giving depositors a haircut as well.

The Cyprus solution is so disturbing because, hearkening back to Obama's auto bailout, it completely upends seniority and distribution of risk on a company balance sheet. Whereas depositors should be the most senior creditors and equity holders the least (so that equity holders take the first loss and depositors take the last), Cyprus has completely reversed this.

One reason that should never be discounted for such behavior is cronyism. In the US auto industry, for example, Steven Rattner and President Obama engineered a screwing of secured creditors in favor of the UAW, which directly supported Obama's election. In Cyprus, I have no doubt that the large banks have deep tendrils into the ruling government.

But it is doubtful that the Cyprus banks have strong influence over, say, Germany, and that is where the bailout and its terms originate. So why is Germany bailing out Cyprus bank owners? Well, there are two reasons, at least.

First, they are worried about a chain reaction that might hurt Germany's banks, which most definitely do have influence over German and EU policy. There is cronyism here, but perhaps once removed.

But even if you were to entirely remove cronyism, Germany and the EU have a second problem: They absolutely rely on the banks to consume their new government debt and continue to finance their deficit spending. Far more than in the US, the EU countries rely on their major banks continuing to leverage up their balance sheets to buy more government debt. The implicit deal here is: You banks expand your balance sheets and buy our debt, and we will shelter you and prevent external shocks from toppling you in your increasingly precarious, over-leveraged position.

Update: Apparently, there is very little equity and bondholder debt on the balance sheets -- its depositor money or nothing. My thoughts: First, the equity and bondholders better be wiped out. If not, this is a travesty. Two, the bank management should be gone -- it is as bad or worse to bail out to protect salaried manager jobs as to protect equity holders. And three, if depositor losses have to be taken, its insane to take insured depositor money ahead of or even in parallel with uninsured deposits.

Across America's business landscape, the gap between the amount that companies expect to owe retirees and what they have on hand to pay them was an estimated $347 billion at the end of 2012. That is better than the $386 billion gap recorded at the end of 2011, but the two years represent the worst deficits ever, according to J.P. Morgan Asset Management.

The firm estimates that companies now hold only $81 of every $100 promised to pensioners.

In general, everything happening on the liability side of the pension equation is working against companies. A big source of the problem: persistently low interest rates, set largely by the Federal Reserve....

Pension liabilities change over time as employees enter and leave a pension plan. For financial-reporting purposes, companies use a so-called discount rate to calculate the present value of payments they expect to make over the life of their plan.

The discount rate serves as a proxy for the hypothetical interest rate that an insurance company would expect on a bond today to fund a company's future pension payments. The lower the discount rate, the greater the company's pension liabilities.

Boeing's discount rate, for example, fell to 3.8% last year from 6.2% in 2007. The aircraft manufacturer said in a securities filing that a 0.25-percentage-point decrease in its discount rate would add $3.1 billion to its projected pension obligations.

Boeing reported a net pension deficit of $19.7 billion at the end of 2012.

The discount rate is based on the yields of highly rated corporate bonds—double-A or higher—with maturities equal to the expected schedule of pension-benefit payouts.

Moody's decision last summer to lower the credit rating of big banks hurt UPS and other companies by booting those banks out of the calculation. And because bonds issued by some of those banks carried higher yields than other bonds used in the calculation, UPS's discount rate fell 1.20 percentage points.

This is obviously not a wildly productive use of corporate funds, to divert ever-increasing amounts of money to pay people who are no longer producing. But at least corporations are acknowledged the problem (I will give credit where it is due -- thanks to accounting rules and government regulations that force a fair amount of transparency here).

It is interesting to note the Boeing example, where their expected rate of return on pension funds fell from 6.2% to 3.8%. Compare that to corrupt government entities like Calpers, which bravely faced this new reality by cutting its discount rate from an absurd 7.75% to a still absurd 7.5%. This despite returns last year around 1%. By keeping the number artificially high, Calpers is hiding its underfunding problem. An interesting reform would be to force Calpers to use a discount rate equal to the average of that used by the 10 largest private pension funds.

In a world where I as a taxpayer have to bail out banks, I don't have a huge problem with capital requirements for banks, though this seemingly simply topic is rife with unintended consequences -- I have seen it argued persuasively that the pre-2008 Basil capital requirements helped fuel the housing bubble by giving special preference to MBS in computing capital. In fact, one might argue the same for the sovereign debt crisis, that by creating a huge demand for sovereign debt for bank balance sheets it fueled an unsustainable expansion in such debt.

Anyway, the point of this post was capital controls. Drum quotes this from an IMF report:

19. Indeed, as the recent global financial crisis has shown, large and volatile capital flows can pose risks even for countries that have long been open and drawn benefits from capital flows and that have highly developed financial markets. For example, in several advanced economies, financial supervision and regulation failed to prevent unsustainable asset bubbles and booms in domestic demand from developing that were partly fueled by cheap external financing. Rather than favoring closed capital accounts, these experiences highlight the need for policymakers to remain vigilant to the risks. In particular, there is a constant need for sound prudential frameworks to manage the risks that capital inflows can give rise to, which may be exacerbated by financial innovation.

The logic, then, is that bubbles are exacerbated by inflows of foreign capital so capital controls can keep bubbles from getting worse. I have very little knowledge of international finance, but let me test three thoughts I have on this:

Doesn't this cut both ways? If bubbles can be inflated by capital inflows, can't they also be deflated by capital outflows? Presumably, if people domestically see the bubble, they would logically look for other places to invest their money. International investments outside of the overheated domestic market are a logical alternative, and such capital flows would act a s a safety valve to reduce pressure on the bubble. So wouldn't capital controls just as likely make bubbles worse, by confining capital within the bubble, as make them better by preventing new capital from outside the country flowing in?

The implication here is that the controls would be dynamic. In other words, some smart person in government would close the gates when a bubble starts to build and open them at other times. But does that not presupposed the ability to see the bubble when one is in it? Certainly there were a few who pointed out the housing bubble before 2008, but few in power did so. And even if they had seen it, what is the likelihood that they would have pointed it out or taken action? Who wants to be the politician who pops the bubble? Remember the grief Greenspan got for pointing to an earlier bubble?

Controls on capital inflows tend to be anti-consumer. Yeah, I know, no one in government ever seems to care when they pass protectionist laws that protect 100 tire workers at the cost of higher tires for 100 million drivers. But limiting capital inflows would reduce the value of the dollar, and make anything imported (or made from imported parts or materials) more expensive.

Once upon a time, government officials decided it would help them keep their jobs if they could claim they had expanded the middle class. Unfortunately, none of them really understood economics or even the historical factors that led to the emergence of the middle class in the first place. But they did know two things: Middle class people tended to own their own homes, and they sent their kids to college.

So in true cargo cult fashion, they decided to increase the middle class by promoting these markers of being middle class. They threw the Federal government strongly behind promoting home ownership and college education. A large part of this effort entailed offering easy debt financing for housing and education. Because the whole point was to add poorer people to the middle class, their was a strong push to strip away traditional underwriting criteria for these loans (e.g. down payments, credit history, actual income to pay debt, etc.)

We know what happened in the housing market. The government promoted home ownership with easy loans, and made these loans a favorite investment by giving them a preferential treatment in the capital requirements for banks. And then the bubble burst, with the government taking the blame for the bubble. Just kidding, the government blamed private lenders for their lax underwriting standards, conviniently forgetting that every President since Reagan had encouraged such laxity (they called it something else, like "giving access to the poor", but it means the same thing).

The scary part was found by Zero Hedge in the footnotes of the report, which admit that this number is understated by as much as half, meaning the true delinquency rate of student debt may be north of 20%.

The Journal article linked above explains why this is:

Nearly all student loans—93% of them last year—are made directly by the government, which asks little or nothing about borrowers' ability to repay, or about what sort of education they intend to pursue.

President Barack Obama championed easy-to-get loans during the campaign, calling higher education "an economic imperative in the 21st century." A spokesman for Education Secretary Arne Duncan said the goal is "to make student loans available to as many people as possible," and requiring minimum credit scores would block many Americans

Any of this sound familiar? I seldom learn much from anecdotes in new stories since it is too easy to craft a stirring anecdote on either side of just about any issue. But I was amazed at the story of the woman who was issued $184,500 in student debt to send her son to college when her entire income is a $1600 a month disability check.

By putting large banks in a special class -- essentially too big to fail -- it ensures that these banks will be able to raise capital far more easily than can smaller banks, since investments in larger banks are essentially guaranteed by the US government. This is the same mechanism by which Fannie and Freddie crowded out most other sources of mortgage financing.

By creating an enormous mass of new regulations, large banks get a cost advantage because they can much more easily pay these fixed costs as they are amortized over a much larger business.

The U.S. Department of Justice and New York Attorney General Eric Schneiderman teamed up last week to sue J.P. Morgan in a headline-grabbing case alleging the fraudulent sale of mortgage-backed securities.

One notable detail: J.P. Morgan didn't sell the securities. The seller was Bear Stearns—yes, the same Bear Stearns that the government persuaded Morgan to buy in 2008. And, yes, the same government that is now participating in the lawsuit against Morgan to answer for stuff Bear did before the government got Morgan to buy it....

As for the federal government's role, it's helpful to recall some recent history: In the mid-2000s, Bear Stearns became—outside of Fannie Mae and Freddie Mac—perhaps the most reckless financial firm in the housing market. Bear was the smallest of the major Wall Street investment banks. But instead of allowing market punishment for Bear and its creditors when it was headed to bankruptcy, the feds decided the country could not survive a Bear failure. So they orchestrated a sale to J.P. Morgan and provided $29 billion in taxpayer financing to make it happen.

The principal author of the Bear deal was Timothy Geithner, who was then the president of the Federal Reserve Bank of New York and is now the Secretary of the Treasury. Until this week, we didn't think the Bear intervention could look any worse.

Somewhere there was a legal department fail here - I can't ever, ever imagine buying a company with Bear's reputation that was sinking into bankruptcy without doing either via an asset sale or letting the mess wash through Chapter 7 so there could be an old bank / new bank split. But Bank of America made exactly the same mistake at roughly the same time with Countrywide, so it must have appeared at the time that the government largess here (or the government pressure) was too much to ignore.

I have been watching the old PBS documentary series (in that Ken Burns style but I don't think by Ken Burns) and found this an interesting story of government policy fail that I had never heard much about. Much like segregated train and bus service, racial redlining that is commonly blamed on private enterprise in fact began as government policy

Government policies began in the 1930s with the New Deal's Federal Mortgage and Loans Program. The government, along with banks and insurance programs, undertook a policy to lower the value of urban housing in order to create a market for the single-family residences they built outside the city.

The Home Owners' Loan Corporation, a federal government initiative established during the early years of the New Deal went into Brooklyn and mapped the population of all 66 neighborhoods in the Borough, block by block, noting on their maps the location of the residence of every black, Latino, Jewish, Italian, Irish, and Polish family they could find. Then they assigned ratings to each neighborhood based on its ethnic makeup. They distributed the demographic maps to banks and held the banks to a certain standard when loaning money for homes and rental. If the ratings went down, the value of housing property went down.

From the perspective of a white city dweller, nothing that you had done personally had altered the value of your home, and your neighborhood had not changed either. The decline in your property's value came simply because, unless the people who wanted to move to your neighborhood were black, the banks would no longer lend people the money needed to move there. And, because of this government initiative, the more black people moved into your neighborhood, the more the value of your property fell.

The Home Owners' Loan Corporation finished their work in the 1940s. In the 1930s when it started, black Brooklynites were the least physically segregated group in the borough. By 1950 they were the most segregated group; all were concentrated in the Bedford-Stuyvesant neighborhood, which became the largest black ghetto in the United States. After the Home Owners Loan Corp began working with local banks in Brooklyn, it worked with them in Manhattan, the Bronx, and Queens.

The state also got involved in redlining. (Initially, redlining literally meant the physical process of drawing on maps red lines through neighborhoods that were to be refused loans and insurance policies based on income or race. Redlining has come to mean, more generally, refusing to serve a particular neighborhood because of income or race.) State officials created their own map of Brooklyn. They too mapped out the city block by block. But this time they looked for only black and Latino individuals.

The academics interviewed in the series argued that nearly every black ghetto in the country was created in the 1930's by this program.

This is a note for small businesses that deposit a lot of cash and small checks, perhaps from a retail operation. We have found that the fees of the large banks are simply awful for retail deposit accounts. Bank of America, Wells Fargo, US Bank, and Zions are all fairly large banks who have raised fees as high as $100+ a month just for a checking account into which we make a weekly deposit of cash and small checks. In particular, US Bank has taken over two of our small deposit banks recently, and raised our fee from $7 on one account to over $120 last month.

Even if your main banking relationship is with someone else, look for a small local bank or credit union for deposit accounts. I have a number of such small banks around the country that charge us zero a month for our deposit account, and at worst up to $10. Anything more, and you can probably do better.

Rolling Stone Magazine has an good story on the conviction of a number of banks and brokers on charges of bid-rigging, specifically on contracts for short-to-medium term management of municipal bond cash accounts. Apparently brokers were paid by certain banks to be given a look at all the other bids before they made their final bid. The article focuses mainly on the ability of winning bidders not to bid any higher than necessary, though I would suppose there were also times when, given this peek, the winning bidder actually raised its bid higher than it might have to ace out other bidders.

This is classic government contracting fraud and it's great to see this being rooted out. I am not wildly confident it is going to go away, but any prosecutorial attention is welcome.

But I am left with a few questions:

It seems that government contracting is more susceptible to this kind of manipulation. Similar stories have existed for years in state highway contracting, and the municipal bond world has had accusations of kick-backs for years. Is this a correct perception, or is the rate of fraud between public and private contracting the same but we just notice more with the government because the numbers are larger, the press coverage is greater, and the prosecutorial resources are more robust?

If government contracting of this sort is more susceptible to fraud, why, and how do we fix it?

The latter is not an academic question for me. I run a company that privately operates public recreation areas. I bid on and manage government contracts. Frequently, a major argument used against the expansion of such privatization initiatives is that past government outsourcing and contracting efforts have been characterized by fraud and mismanagement. The argument boils down to "the government has so many management problems that it can't be trusted with contracting for certain services so it needs to operate those services itself."

The only way to reconcile this view is to assume that private actors are more likely to act fraudulently and be dishonest than public employees. If this were true, then the public would be safer if a public management process of questionable ability were applied towards public employees rather than outside private contractors, because those who were being managed would be less likely to take advantage. And certainly there are plenty of folks with deep skepticism of private enterprise that believe this.

However, I would offer that only by adopting an asymmetric view of what constitutes fraud would we get to this conclusion. Clearly, banks colluding to shave a few basis points off municipal asset returns is fraud. As the author of the Rolling Stone piece puts it several times, the crime here is that the public did not get the best market rate. So why is, say, elected officials colluding with public employees unions to artificially raise wages, benefits, and staffing levels above market rates not fraud as well? In both cases insiders are manipulating the government's procurement and political processes to pay more than the market rates for certain services.

This is Bastiat's "seen and unseen" of the privatization debate. Yes, the world is unfortunately littered with examples of government procurement fraud. This is often cited as a reason for maintaining the status quo of continued government management of a diverse range of services. But what we miss, what is unseen, is that these government services are often run with staffing levels, work rules, productivity expectations, and pay rates that would constitute a scandal if uncovered in a division of a corporation, particularly if the workers were spending a lot of money to make sure the manager handing them this largess was able to keep his job.

Yes, the public lost several basis points on its investments when it did not get the market rate of return from cheating bankers. But it loses as much as 50% of every tax dollar sent to many state agencies because it does not get market rates (and practices) for state labor.

This is really bad news. Investing in these securities is effectively the equivalent of putting money in one's mattress -- it means that investors don't perceive any money-making uses for their money better than paying paying financially strong governments to keep it safe for a while. I am far from an expert on banking regulations, but my first guess on this is that this is at least in part a function of bank capital requirements that effectively require banks to put a lot of cash into government securities no matter how bad the return.

Germany and Switzerland certainly are providing some value in creating a safe haven for capital, but I wonder if in the long-run this is anything but destructive, shifting wealth and investment out of the private economy and into investments with no return.

CDOs and credit default swaps don't kill financial systems, mortgages kill financial systems. There has been altogether too much opproprium directed at CDOs, credit default swaps and other structuring techniques that spread financial contagion, and not enough directed at the underlying collateral. The record seems to be, however, that Dick Pratt was correct when he called the mortgage "the neutron bomb of financial products."

This makes no sense. I don't have time for a comprehensive argument, so here are a few bullet points:

His argument rests on the fact that mortgages have inherently hard-to-quantify risks. I don't believe that, given how long the financial system worked just fine writing mortgages, but if this is really the case, shouldn't he be proposing to ban mortgages, not just mortgage-backed securities?

Holding the higher-quality tranches of an MBS simply cannot, by any mechanism I can fathom, be more risky than holding a lot of individual mortgages. In fact, for a given bank, it should spread the risk geographically and to a larger number of mortgages.

The first actual problem with MBS's is that the default risks were under-estimated by those packaging the securities. Basically, the top AAA tranches were too large (or too wide, I think the term is). This is correctable, and likely already has been corrected (In fact it had more to do with the actions of the government-enforced credit rating oligopoly than with actions of bankers).

The second actual problem with MBS's is that the default risks were under-estimated by government regulators world-wide when in Basil II and the equivalent US law changes c. 1991, MBS's were given very preferential capital requirement treatment. Basically, MBS were treated, for capital requirements, as if they were nearly as risk-free as US treasuries, providing incentives for banks to over-weight in them.

The largest problem was the reduction in credit requirements for mortgages. Increasing LTV from 80% to 97% or 100% or even 100%+ hugely increased the risk of default, and no one really took that into account in MBS packaging or bank capital requirements. Bank capital requirements for mortgages and MBS were set as if they were European style recourse loans with 80% LTV. But the same regulations and requirements applied to MBS built on US-style non-recourse loans with 97% LTV, which is crazy.

The Left continues to push the myth that government "austerity" (defined as still running a massive deficit but running a slightly smaller massive deficit) is somehow pushing Europe into a depression. Well, this myth-making worked with Hoover, who is generally thought to have worsened the Depression through austerity despite the reality that he substantially increased government spending.

It is almost impossible to spot this mythical austerity beast in action in these European countries. Sure, they talk about austerity, and deficit reduction, and spending increases, but if such talk were reality we would have a balanced budget in this country. If one looks at actual government spending in European nations, its impossible to find a substantial decline. Perhaps they are talking about tax increases, which I would oppose and have been occurring, but I doubt the Left is complaining about tax increases.

Seriously, I would post the chart showing the spending declines but I can't because I keep following links and have yet to find one. I keep seeing quotes about "commitment" to austerity, but no actual evidence of such.

Let's take Britain. Paul Krugman specifically lashed out at "austerity" programs there are undermining the British and European economy. So, from this source, here is actual and budgeted British government spending by year, in billions of pounds:

2007: 544.0

2008: 575.7

2009: 621.5

2010: 660.6

2011: 683.4

2012: 703.4

2013: 722.2

Seriously, I will believe the so-called austerity when someone shows it to me. And this is not even to mention the irresponsibility of demanding more deficit spending without even acknowledging the fact that whole countries already have so much debt they are teetering on the edge of bankruptcy.

Here is the European problem -- they are pouring hundreds of billions of Euro into bailing out failed banks and governments. They are effectively taking massive amounts of available resources out of productive hands and pouring it into failed institutions. Had they (or we) let these institutions crash four years ago, Europe would be seeing a recovery today. The hundreds of billions of Euros used to keep banks on life support could have instead been used to mitigate the short term effects of bigger financial crash.

It is an open question how long this bailout will plug the dam. I continue to maintain the position that Greece is going to have to be let out of the Euro. Pulling this Band-Aid off a millimeter at a time is delaying any possible recovery of the Greek economy, and really the European economy, indefinitely. All to protect the solvency of a number of private banks (or perhaps more accurately, to protect the solvency of the counter-parties who wrote the CDO's on all that debt).

Anyway, the interesting part for me is that with this bailout, the total cumulative charity sent the Greek's way by other European countries now exceeds Greek GDP, by a lot.

Investors have a saying - your first loss is your best loss. In other words, if you think an investment sucks, swallow your pride, take your lumps, and get out entirely now.

This is NOT how we have dealt with the financial crisis. Through a series of bailouts, we have tried to keep failing financial institutions and countries on life support. We have dragged out the reckoning on mortgages, so we still have not had a real clearing in the real estate market. Worse, we have postponed, even entirely interrupted, financial accountability for those who made bad investments or took on too much debt.

Here is an interesting counter-example - Iceland, which basically went entirely bankrupt along with pretty much all their banks, is on the road to recovery.

One of the amazing aspects of our new post-modern outlook on personal responsibility and obligations is that folks who are profligate and take on too much debt are increasingly considered victims to which other people owe something (generally a bailout).

Greek Prime Minister Lucas Papademos told lawmakers to back a deeply unpopular EU/IMF rescue in a vote on Sunday or condemn the country to a "vortex" of recession.

He spoke in a televised address to the nation, ahead of Sunday's vote on 3.3 billion euros ($4.35 billions) in wage, pension and job cuts as the price of a 130-billion-euro bailout from the European Union and International Monetary Fund.

The effort to ease Greece's huge debt burden has brought thousands into the streets in protest, and there were signs on Saturday of a small rebellion among lawmakers uneasy with the extent of the cuts.

So outsiders generously agree to pay for 130 billion Euros of past Greek spending if only the Greeks will cut their current spending by 3.3 billion Euros (at which spending level the country would still be running large deficits). And people riot as if they have been gang-raped. Incredible.

Let the Greeks go. Of course, this is not actually about bailing out Greece, but about bailing out, indirectly, European banks that invested in Greek bonds. The banks seem to run public policy in Europe, even more so than in the US.

As I predicted, the various highly touted European debt and currency interventions last month did squat. This is no surprise. The basic plan currently is to have the ECB give essentially 0% loans to banks with the implied provision that they use the money to buy sovereign debt. Eventually there are provisions for austerity, but I wrote that I don't think it's possible these will be effective. It's a bit unclear where this magic money of the ECB is coming from - either they are printing money (which they refuse to own up to because the Germans fear money printing even more than Soviet tanks in the Fulda Gap) or there is some kind of leverage circle-jerk game going where the ECB is effectively leveraging deposits and a few scraps of funding to the moon.

At this point, short of some fiscal austerity which simply is not going to happen, I can't see how the answer is anything but printing and devaluation. Either the ECB prints, spreading the cost of inflation to all counties on the Euro, or Greece/Spain/Italy exit the Euro and then print for themselves.

The exercise last month, as well as the months before that, are essentially mass hypnosis spectacles, engineered to try to get the markets to forget the underlying fundamentals. And the amazing part is it sort of works, from two days to two weeks. It reminds me of nothing so much as the final chapters of Atlas Shrugged where officials do crazy stuff to put off the reckoning even one more day.

Disclosure: I have never, ever been successful at market timing investments or playing individual stocks, so I generally don't. But the last few months I have had fun shorting European banks and financial assets on the happy-hypnosis news days and covering once everyone wakes up. About the only time in my life I have made actual trading profits.

Thought problem: I wish I understood the incentives facing European banks. It seems like right now to be almost a reverse cartel, where the cartel holds tightly because there is a large punishment for cheating. Specifically, any large bank that jumps off the merry-go-round described above likely starts the whole thing collapsing and does in its own balance sheet (along with everyone else's). The problem is that every day they hang on, the stakes get higher and their balance sheets get stuffed with more of this crap. Ironically, everyone would have been better getting off a year ago and taking the reckoning then, and certainly everyone would be better taking the hit now rather than later, but no one is willing to jump off. One added element that makes the game interesting is that the first bank to jump off likely earns the ire of the central bankers, perhaps making that bank the one bank that is not bailed out when everything crashes. It's a little like the bidding game where the highest bidder wins but the two highest bidders have to pay. Anyone want to equate this with a defined economics game please do so in the comments.

The [Greek] government has decided to stop tax returns and other obligation payments to enterprises, salary workers and pensioners as it sees the budget deficit soaring to over 10 percent of gross domestic product for 2011.

For all the supposed austerity, the budget situation is worse in Greece. Germany and other countries will soon have to accept they have poured tens of billions of euros down a rathole, and that they will have to do what they should have done over a year ago - let Greece move out of the Euro.

Government workers and pensioners simply will not accept any cuts without rioting in the street. And the banks will all go under with a default on government debt. And no one will pay any more taxes. And Germany is not going to keep funding a 10% of GDP deficit. The only way out seems to be to print money (to pay the debt) and devalue the currency (to effectively reduce fixed pensions and salaries). And the only way to do all that is outside of the Euro. From an economic standpoint, the inflation approach is probably not the best, but it is the politically easiest to implement.

For a while now, a few authors have been quipping at Zero Hedge that the best investment strategy is to do the opposite of what Goldman Sachs is telling is retail customers. The theory is that if Goldman tells the public to buy, it means that they are selling like crazy for their own account.

This seemed a bit cynical, but on Friday Zero Hedge observed that Goldman was telling its retail customers to buy European banks. This advice seemed so crazy -- the European agreement last weekly explicitly did not contain anything to help banks in the near term with over-leveraged bets on shaky sovereign debt -- that for the fun of it I played along. I shorted a couple hundred shares of EUFN, a US traded fund of European financial firms (took a bit of work to find the shares to borrow).

Today, US markets are rallying strongly (Dow up 400 points or so at the moment) on news of coordinated central bank action that, that .... that what? It looks to me like the US and European banks are merely building up liquidity in preparation for potential bank runs. I would have considered this bad news, kind of like news we just went to DEFCON 2, but for some reason the market is rallying (though there was also an ADP report saying hiring was way up last month, which is certainly good news).

As I wrote yesterday, there only appear to be 3 solutions to the European debt crisis and this is not one of them. If I am right and patterns hold, the markets will wake up in a day or two and say, "wait, there is still trillions of Euros of deteriorating sovereign debt sitting on bank balance sheets with 40:1 leverage ratios" and fall back. I am thrilled that our economy shows signs of life and I know that corporate profits have been good, but I don't see any way a European debt crash won't have substantial negative effects on the US. If I am wrong, the market will continue up, up and away and you should stop ever listening to me because I clearly don't understand squat.

Update: Yesterday I posited that real solutions were going to be a combination of 1) default/haircut 2) Make someone else pay back the debt and 3) print money. I have heard it argued this morning that today's announcement may be evidence of #2 (ie, US taxpayers will bail them out) or more likely #3 (since the ECB can't print money, but the Fed seems to be doing a lot of it, lets get the Fed to print more money for the Europeans .... I don't understand the mechanics well enough to pinpoint who would bear the inflationary consequences of this, but betting on the US to be the world's patsy is never a bad bet).

The default option will almost certainly wipe out a lot of powerful banking and financial interests as well as make it very hard for governments to keep spending money at their historic pace. This will certainly have a bad effect on the larger economy, but we should be careful accepting forecasts of economic catastrophe as most of these come from these same powerful bankers and politicians. Every group, down to the local dog catchers, argue that the world will suffer a calamity if their particular profession is harmed. What we do know is that large banks and financial companies are even more intertwined with the political elite in Europe than they are in the US. We can be pretty certain that, push come to shove, a solution that saves the banks and allows politicians to keep spending will be preferred.

That is why the Europeans will likely end up printing money to pay off the debt. They almost certainly would be doing so already,were it not for Germany’s strong memories of its Weimar inflation years, when exactly this kind of money printing to pay down government debt led to hyperinflation and political instability. But the appeal to politicians of shifting the costs from themselves and banks to the average consumer is simply too great to pass up. If Germany can be convinced, then the European Central Bank will print Euros. If Germany cannot be convinced, then countries will leave the Euro and print Lira and Drachma.

I will leave aside the issue of the recently revealed massive loans from the Fed to various banks. It can be argued that being the provider of last resort for short-term liquidity in the banking system is a legal, even legitimate, role for the Fed.

But scan this list. Here are some of the "banks" that got close near-interest-free money from the Fed

Verizon

Chrysler

Caterpillar

Harley-Davidson

Baxter International

I presume these loans were nominally for their financing arms, but what is the systematic-risk argument for backstopping manufacturer's credit operations?

When I was at McKinsey & Co, part of their relocation package was a $10,000 interest-free one year loan. I had any number of new recruits say they did not need the loan. I told them it was a business IQ test. If you turned down the loan, we revoked your job offer (just kidding, of course). I took the loan and dropped it into T-bills.

I wonder how many of these recipients really needed the money to survive or just got smart enough to claim dire need and took the money and just dropped it into something interest-bearing.

The theme from all these failures is distorted signals and corrupted communication. People, no matter how savvy, cannot possibly research every nook and cranny of the economy before making an investment. They make decisions, therefore, based on signals – prices, interest rates, perceived risks, and the profit history of other similar investments. If these signals are artificially altered or corrupted, bad decisions that destroy wealth and growth will result.

Which brings me back to education. I will tell you something almost every business owner knows: We business owners may whine from time to time that banks won’t lend us money, but what really is in short support are great people. Nothing has more long-term impact on an economy than amount and types of skills that are sought by future workers. That is why everyone accepts as a truism that education is critical to economic health.

Unfortunately, there is good evidence that our education policies have already done long-term harm. The signals we send to kids making their higher education plans have disconnected them from reality in a number of fundamental ways, causing them to make bad decisions for themselves and the broader economy.

We are very, very close to seeing much of the financial system blow up because banks, particularly in Europe, have bought sovereign debt and leveraged it 30x to 40x. The theory was that sovereign debt denominated in Euros, yen, or dollars was essentially risk-free. Once that theory was proved to be bankrupt, financial institutions are now claiming all their sovereign debt is perfectly hedged. I think we will find that untrue as well. Hedging mechanisms don't work when the whole of the market is tanking -- its a similar problem to why earthquake insurance does not work. No insurance company or counter-party can pay off when every single policy has a claim.

Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. You may recall that this became the centerpiece of TARP once Hank Paulson decided that the money would be better spent directly buying into the banks as opposed to overpaying them for dodgy asset-backed bonds. (Mind you, other parts of TARP were spent overpaying for dodgy asset-backed bonds.)

The CPP lasted a little more than a year and invested $205 billion of taxpayer funds into various qualifying institutions. Not every bank that filled out the 2-page application was successful in gaining access. Others were approved but ultimately decided not to take the funds (probably because of the attached restrictions on pay and on paying out dividends.) In the end, 707 financial institutions received the funds.

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand.

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find?

They found more risk, across the board. There is a lot of detail, so I will leave it to you to go to the source for more, but Zero Hedge concludes:

The bail-out itself increased our chances of having the bail the banks out all over again. Moral hazard is no longer in the realm of the abstract

A few months ago I went through an unbelievable hassle refinancing my loan. Based on current appraisals, my loan to value was less than 50%, but I still ended up coming to the table with more equity to reduce the new loan size. I was staggered at how hard it was to close what should have been a dead-safe loan, given the LTV and my income and credit history. The study actually has a finding related to that:

“This pattern would be consistent with a strategy aimed at originating high-yield assets, while improving bank capitalization ratios, since the key capitalization ratios do not distinguish between prime and subprime mortgages.”

This is a fascinating sort of metric manipulation. Having my loan go from 45% to 40% LTV does nothing, really, for the overall safety of the bank, but it improves their averages and makes them look safer, while all the way they are actually engaging in more risky behavior.

I don't have time today to link all the evidence, but the combination of crashing real estate markets and the Chinese government jamming liquidity into its banks tells me the China bubble is bursting as we speak.

This is an interesting test of the Austrian view of depressions vs. the Keynesian / Krugman / Thomas Friedman / MITI view of government-orchestrated prosperity. If the latter are right, then China is doing more right to keep their economy going than any country in history and you should go invest all your money in Chinese real estate.

However, if one believes the Austrian model about government-enforced mis-allocation of capital and labor leading to bubbles and crashes; if one believes that the technocrat-beloved MITI was largely responsible for the Japanese lost decade; if one believes that the US govenrment through articially low interest rates and government-directed reductions in underwriting quality helped create the housing bubble -- then the mother of all crashes is looming in China. Because no country has done more to reallocate resources and capital based on the whims of a few technocrats and well-connected industrialists than has China. After all, this is why Thomas Friedman loves China, that it does not rely on the judgement of millions of individuals to allocate capital, but instead on the finger pointing of a few at the top.